The Hedge Fund Managers Tax Break: Because Wall Streeters Want Your Money

04/14/2014 03:38 pm 15:38:05 | Updated Jun 14, 2014

The coming of tax day provides a great opportunity for everyone to focus on their favorite tax break, and there are many from which to choose. However for all the sneaky and squirrelly ways that the rich use to escape their tax liability, none can beat the hedge fund managers' tax break. This is the way the rich tell the rest of us, because they are rich and powerful, the law doesn't apply to them.

The hedge fund managers' tax break, which is also known as the carried interest tax deduction, is different from other tax breaks in that it has no economic rationale. With most other tax breaks there is at least an argument as to how it serves some socially useful purpose. That is not the case with the hedge fund managers' tax break. This is simply a case where the rich don't feel like paying taxes and are saying to the rest of us, "what are you going to do about it?"

The hedge fund managers' tax break applies to the portion of their earnings that are contingent on the performance of their fund. It's standard for hedge fund managers to be paid a flat fee of 1-2 percent of the money they manage. In addition, they will typically get performance pay that is equal to 10-20 percent of what the fund earns above some threshold. Managers of private equity funds and real estate investment trusts have similar arrangements with the same tax break.

The portion of their pay that depends on the fund's performance is the "carried interest." It often runs into the tens of millions or even hundreds of millions of dollars. While this money is clearly and explicitly pay for the work of managing the fund, under the current tax law managers get to have this income taxed at the capital gains rate.

This translates into a huge savings for the fund managers. If their earnings were taxed as normal income they would pay a 39.6 percent tax rate, compared to just a 20 percent capital gains tax rate. For a successful manager earning $10 million, the savings come to $1,960,000. If they earned $100 million, the savings would be equal to $19,600,000.

The Wall Streeters arguments as to why they shouldn't have to pay the same tax rate as everyone else are basically just jokes. They have paid lobbyists to write lengthy papers explaining that carried interest is not really a payment for earnings, it rather it is the profits from a put option on the assets of the fund.

Of course a realtor or a car salesperson could make the same argument about the portion of their pay that is contingent on their sales. The 6 percent fee charged by the realtor is not really pay for their work, it is a put option for a portion of the sales price of the house. Unfortunately for realtors they don't have enough money to force members of Congress and the media to take this nonsense seriously.

The other line the hedge fund managers argue is that it is good for the managers to have their interests allied with the investors in their fund. If what the managers take home depends on what the fund earns, they will have more incentive to ensure the fund does well.

This is a fine argument, but it has nothing to do with why the taxpayers should subsidize their income. There is no reason they can't sign contracts with their investors which will require that either the fund managers put up a substantial portion of their money upfront or reinvest a portion of their overhead fee, so that they will have their own money at stake. Such contracts are simple to write and they have the great benefit that they don't require the taxpayer's money.

The fund managers' tax break first became a major political issue seven years ago. It seemed so obviously corrupt that it couldn't stand up in the light of day. When I first heard about it from a friend I assumed that he had misunderstood its nature since no tax break could be such a blatant give away to the rich. I then looked it up and realized that he was right.

I then asked a prominent conservative economist how he would justify this tax break. He told me that the fund managers are rich and powerful people. I assured him I knew this, but I wanted to know what sort of economic rationale there could be for this sort of tax break. He said there isn't one.

So there you have it. The richest people in the country don't pay their taxes because they don't feel like it. Happy Tax Day.